FX Strategy

FX Strategy

Article Main Body

Overview

The currency market is one of the largest and most liquid financial markets in the world. Currencies like the U.S. dollar, the euro and the yen trade in the foreign exchange (FX) market 24 hours a day, fluctuating in value relative to each other almost constantly.

In order to be successful in adding value in currencies, an active manager must have a deep understanding of global macroeconomics and utilize that knowledge to develop forward-looking strategies. PIMCO is one of the largest active global fixed income managers in the world; we have been investing in the currency markets since 1987, and currency strategies are an important component in many of our active fixed income portfolios. PIMCO has devoted extensive resources to developing our expertise in the global financial markets. Our experienced investment professionals around the globe provide valuable strategy ideas as well as insights into local and regional macroeconomic developments and currency policies.

PIMCO’s bottom-up quantitative approach focuses on gaining exposure to structural currency beta by exploiting the forward-rate bias, or the tendency for high-yielding currencies to appreciate relative to low-yielding currencies.

PIMCO’s tail risk hedging is overlaid on top of the currency portfolio constructed from our quantitative and qualitative process, and uses derivatives and other instruments, as well as dynamic management of currency position scaling, to manage risks that could arise from severe and sudden market shocks.

PIMCO applies the same secular and cyclical investment process we use for bond management to currency management. PIMCO’s currency investment process includes both top-down and bottom-up decision-making.

The PIMCO investment process starts with the PIMCO annual Secular Forum during which the firm develops its three- to five-year outlook for the global economy. In the currency space, we incorporate analysis of relative interest rates, inflation rates, real exchange rates, purchasing power parity, monetary and fiscal policies, trade account balance and current account balance among other factors to determine our long-term currency exposures.

Then, PIMCO investment professionals meet quarterly in Cyclical Economic Forums to evaluate growth and inflation over the business cycle horizon of the next six to 12 months. During this process, we discuss factors that influence exchange rates in the short term, such as flows, market technicals and government policy, in an effort to refine our bottom-up selection process for both long and short currency exposures.

Applications for FX Strategies

Actively managed currencies may provide investors a diversified source of excess returns that generally are uncorrelated with other asset classes, such as stocks or bonds. Also, investments in foreign currencies may help preserve investors’ purchasing power and better enable them to meet domestic liabilities.

A typical “passive” unhedged portfolio has concentrated, asymmetric risk profile, where the currency risk factor is entangled with other risk factors of equities and fixed income securities. An active currency strategy may separate and manage this risk factor through long, short or neutral exposure to foreign currencies.

PIMCO’s FX Strategy is highly scalable and can be tailored to investors’ risk and return goals. This approach can be implemented as an absolute return strategy or an unfunded overlay strategy, where exposures could be obtained with low levels of invested capital. Return and volatility targets as well as leverage can be customized to meet each investor’s needs.

Sources of Added Return

A key factor underlying active currency returns is the existence of market inefficiencies. Participants as varied as central banks, corporate hedgers, institutional fund managers and even tourists transact in the foreign exchange markets for a variety of reasons, many of them not driven by profit motives. Central banks, for example, typically intervene in the markets, buying or selling their currencies to dampen volatility or defend a particular level deemed important psychologically or politically. Corporations with sales or operations outside their home country may hedge currency exposures in order to minimize earnings volatility. Often, international asset flows are driven by asset allocation decisions and these pass through the currency markets without regard for a particular currency’s valuation, level or fundamentals. Finally, tourists are the ultimate price takers, buying or selling currencies at levels that prevail when they choose to travel. Transactions in the foreign exchange markets driven by such varying motivations can shift short-term market volatility and affect valuations. An active currency strategy aims to exploit these market inefficiencies in order to seek excess returns.

Another important source of value in an active currency strategy arises from diverging expectations among market participants of the fundamental future value of a currency. While term structure and cash flow models underpin fixed income and equity valuations, no universally acknowledged valuation methodology exists to assess fair value for a particular currency. This lack of consensus on valuation also creates a market inefficiency that an active currency manager seeks to exploit to add value.

Also, secular global economic realignments may be expressed in the form of currency revaluations, providing opportunities for investors to enhance portfolio returns through structural inefficiencies and valuation misalignment in the currency markets.

​

How To Invest

Past performance is not a guarantee or a reliable indicator of future results.All investments contain risk and may lose value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.Diversification does not ensure against loss.

There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.